1. c h a p t e r fifteen © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. Prepared by: Fernando & Yvonn Quijano Fiscal Policy

2. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 15: Fiscal Policy 2 of 39 Fiscal Policy LEARNING OBJECTIVE 1 Fiscal policy Changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives, such as high employment, price stability, and high rates of economic growth. What Fiscal Policy Is and What It Isn’t Automatic Stabilizers versus Discretionary Fiscal Policy Automatic stabilizers Government spending and taxes that automatically increase or decrease along with the business cycle.

3. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 15: Fiscal Policy 3 of 39 Fiscal Policy An Overview of Government Spending and Taxes 15 - 3 Federal Government Expenditures, 2004

4. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 15: Fiscal Policy 4 of 39 Fiscal Policy 15 - 4 Federal Government Revenue, 2004 An Overview of Government Spending and Taxes

5. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 15: Fiscal Policy 5 of 39 Using Fiscal Policy to Influence Aggregate Demand A Summary of How Fiscal Policy Affects Aggregate Demand PROBLEMTYPE OF POLICY ACTIONS BY CONGRESS AND THE PRESIDENTRESULT RecessionExpansionaryIncrease government spending or cut taxes Real GDP and the price level rise Rising Inflation ContractionaryDecrease government spending or raise taxes Real GDP and the price level fall Countercyclical Fiscal Policy 15 – 1

6. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 15: Fiscal Policy 6 of 39 The Government Purchases and Tax Multipliers LEARNING OBJECTIVE 3 15 - 7 The Multiplier Effect and Aggregate Demand Multiplier effect The series of induced increases in consumption spending that results from an initial increase in autonomous expenditures.

7. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 15: Fiscal Policy 7 of 39 The Government Purchases and Tax Multipliers

8. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 15: Fiscal Policy 8 of 39 The Limits of Using Fiscal Policy to Stabilize the Economy LEARNING OBJECTIVE 4 15 - 10 How a Bill Becomes Law

9. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 15: Fiscal Policy 9 of 39 The Limits of Using Fiscal Policy to Stabilize the Economy Does Government Spending Reduce Private Spending? Crowding out A decline in private expenditures as a result of an increase in government purchases.

10. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 15: Fiscal Policy 10 of 39 The Limits of Using Fiscal Policy to Stabilize the Economy 15 - 11 An Expansionary Fiscal Policy Increases Interest Rates Crowding Out in the Short Run

11. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 15: Fiscal Policy 11 of 39 Deficits, Surpluses, and Federal Government Debt LEARNING OBJECTIVE 5 Budget deficit The situation in which the government’s spending is greater than its tax revenue. Budget Surplus The situation in which the government’s expenditures are less than its tax revenue.

12. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 15: Fiscal Policy 12 of 39 Deficits, Surpluses, and Federal Government Debt 15 - 13 The Federal Budget Deficit, 1901-2004 How the Federal Budget Can Serve as an Automatic Stabilizer

13. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 15: Fiscal Policy 13 of 39 Deficits, Surpluses, and Federal Government Debt Cyclically adjusted budget deficit or surplus The deficit or surplus in the federal government’s budget if the economy were at potential GDP. 15 – 14 How the Level of GDP Affects the Cyclically Adjusted Budget Deficit How the Federal Budget Can Serve as an Automatic Stabilizer

14. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 15: Fiscal Policy 14 of 39 Did Fiscal Policy Fail During the Great Depression? 15 - 3 Although government spending increased during the Great Depression, the cyclically adjusted budget was in surplus most years. FEDERAL GOVERNMENT EXPENDITURES (BILLIONS OF DOLLARS ACTUAL FEDERAL BUDGET DEFICIT OR SURPLUS (BILLIONS OF DOLLARS) CYCLICALLY ADJUSTED BUDGET DEFICIT OR SURPLUS (BILLIONS OF DOLLARS) CYCLICALLY ADJUSTED BUDGET DEFICIT OR SURPLUS AS A PERCENTAGE OF GDP 1929$2.6$1.0$1.241.20% 19302.70.20.810.89 19314.0-2.1-0.41-0.54 19323.0-1.30.500.85 19333.4-0.91.061.88 19345.5-2.20.090.14 19355.6-1.90.540.74 19367.8-3.20.470.56 19376.40.22.552.77 19387.3-1.32.472.87 19398.4-2.12.002.17

15. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 15: Fiscal Policy 15 of 39 The Effects of Fiscal Policy in the Long Run LEARNING OBJECTIVE 6 Tax wedge The difference between the pre-tax and post-tax return to an economic activity. The Long-Run Effects of Tax Policy We can briefly look at the effects on aggregate supply of cutting each of the following taxes:  Individual income tax.  Corporate income tax.  Taxes on dividends and capital gains.

16. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 15: Fiscal Policy 16 of 39 Should the United States Adopt the “Flat Tax”? 15 - 4 Should the United States simplify the tax code by moving to a flat tax? COUNTRY FLAT TAX RATE YEAR FLAT TAX WAS INTRODUCED Estonia26%1994 Lithuania331994 Latvia251995 Russia132001 Serbia142003 Ukraine132004 Slovakia192004 Georgia122005 Romania162005

17. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 15: Fiscal Policy 17 of 39 Automatic stabilizers Budget deficit Budget surplus Crowding out Cyclically adjusted budget deficit or surplus Fiscal policy Multiplier effect Tax wedge

18. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 15: Fiscal Policy 18 of 39 Appendix 15: A Closer Look at the Multiplier An Expression for Equilibrium Real GDP Consumption function Planned investment function Government purchases function Tax function Equilibrium condition

19. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 15: Fiscal Policy 19 of 39 Appendix 15: A Closer Look at the Multiplier The letters with “bars” represent fixed or autonomous values that do not depend on the values of other variables. So, represents autonomous consumption, which had a value of 1,000 in our original example. Now, solving for equilibrium we get: or, An Expression for Equilibrium Real GDP

20. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 15: Fiscal Policy 20 of 39 Appendix 15: A Closer Look at the Multiplier A Formula for the Government Purchases Multiplier or, the government purchases multiplier

21. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 15: Fiscal Policy 21 of 39 Appendix 15: A Closer Look at the Multiplier A Formula for the Tax Multiplier

22. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 15: Fiscal Policy 22 of 39 Appendix 15: A Closer Look at the Multiplier The “Balanced Budget” Multiplier

23. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 15: Fiscal Policy 23 of 39 Appendix 15: A Closer Look at the Multiplier The Effects of Changes in Tax Rates on the Multiplier

24. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 15: Fiscal Policy 24 of 39 Appendix 15: A Closer Look at the Multiplier The Multiplier in an Open Economy We can define the marginal propensity to import (MPI) as the fraction of an increase in income that is spent on imports. So, our expression for imports is: Imports = MPI x Y. We can substitute our expressions for exports and imports into the expression we derived earlier for equilibrium real GDP: where the expression represents net exports.